Speaker 1: Bloomberg Audio Studios, Podcasts, Radio News.
Speaker 2: Hello and welcome to another episode of the Odd Lots podcast.
Speaker 3: I'm Joe Wisenthal and I'm Tracy Allaway.
Speaker 2: Tracy, you know, we do all these episodes about private
Speaker 2: credit and obviously hedge funds, multi strategy hedge funds in
Speaker 2: particular lately, and of course it all sort of seems
Speaker 2: to be part of a bigger story of a bunch
Speaker 2: of things that used to happen inside banks no longer
Speaker 2: happening inside banks.
Speaker 3: Right, And this has been like a continual process ever
Speaker 3: since like the two thousand and eight financial crisis, but
Speaker 3: even before that we had like big periods of bank disintermediation,
Speaker 3: which we talked about recently on that episode with Hugh
Speaker 3: van steinas.
Speaker 2: Totally, there's a lot going on and not all of
Speaker 2: these trends date back to the final victual crisis, but
Speaker 2: you know, this was obviously kind of an express goal.
Speaker 2: I think of the Dobb Frank regulations and just from
Speaker 2: my seed sitting here, like, yeah, it seems pretty good.
Speaker 2: Bunch of risky stuff like multi strategy hedge funds, et cetera,
Speaker 2: seems kind of risky. You can lose a lot of money.
Speaker 2: In theory, lending to random middle market companies seems like
Speaker 2: you could lose a lot of money. It's like, yeah,
Speaker 2: it seems pretty good that it's not happening inside the banks,
Speaker 2: and maybe that's good that it's not connected directly to
Speaker 2: deposit taking institutions.
Speaker 3: Yeah, And I think given the increases we've seen in
Speaker 3: rates over the past couple of years, the fact that
Speaker 3: like nothing really broke or exploded in the private credit
Speaker 3: market seems like a good sign. But again, it's still
Speaker 3: relatively small and it is growing very rapidly, so I
Speaker 3: think there are more questions to be asking about this
Speaker 3: particular space.
Speaker 2: Well, you brought up something recently on an episode of
Speaker 2: Synthetic Risk Transfers where banks sort of offload some of
Speaker 2: their credit risk onto third party entities, And that's really
Speaker 2: stuck in my head, which is, you know, Okay, so
Speaker 2: these third party entities take the risk of the assets
Speaker 2: from the banks, but then that's an asset that can
Speaker 2: be levered up. And where do you get leveraged, presumably
Speaker 2: from a bank, And so I have this like.
Speaker 3: Sort of very circular, isn't it.
Speaker 2: Yeah, And I just have this nagging thing in my
Speaker 2: head somewhere it's like, okay, yeah, great, we moved it
Speaker 2: all off the banks. There's okay, we're not going to
Speaker 2: have another two thousand and eight. But what if the way,
Speaker 2: what if in some way it still goes back to
Speaker 2: the banks. Yea, and the risk still is there and
Speaker 2: it just sort of takes the loop out and then comes.
Speaker 3: It goes into prime brokerage instead of the balance sheet.
Speaker 2: That's a good way to put it. And so like
Speaker 2: I'm still like, I'm like, eh, things pretty good, but
Speaker 2: maybe maybe there are still some reasons to be concerned.
Speaker 2: Can you ever? I guess maybe we could title this
Speaker 2: episode like, can you ever really de risk the banking system?
Speaker 4: Oh?
Speaker 3: That's a good one, let's use that.
Speaker 2: Okay, Well, I am really excited. We have the perfect
Speaker 2: guest on today's show, someone we've had on the podcast
Speaker 2: before and someone we've known and talked to for a
Speaker 2: long time. We're going to be speaking with Stephen Kelly,
Speaker 2: Associate director of Research at the Yale Program on Financial Stability. So, Steven,
Speaker 2: thank you so much for coming back on a lots.
Speaker 4: Great to be back.
Speaker 5: You know, sometimes you guys say literally the perfect guest,
Speaker 5: and so I'm old for too on that I've only
Speaker 5: gotten perfect guests.
Speaker 3: But well, you coming, we have people who complain about
Speaker 3: when we forget to say the perfect guest, but you've
Speaker 3: kicked it up to another level and are complaining about
Speaker 3: not saying, oh, literally the perfect guest. This is a
Speaker 3: new era.
Speaker 2: I do not think that the word perfect does not
Speaker 2: actually need any adjectives, right, because either it's perfect or
Speaker 2: it's not. It's sort of like the word when people
Speaker 2: that call something very unique. It's like either it's unique,
Speaker 2: one of a kinder, it's not. So I wouldn't take
Speaker 2: that too uh, I would agree with you. I wouldn't
Speaker 2: take that too literally.
Speaker 5: I would agree with you if you followed your own Okay, okay,
Speaker 5: that's fair enough.
Speaker 2: Stephen Kelly, literally the perfect guest made that correction. I
Speaker 2: just should I be like I said, Oh, everything seems fine.
Speaker 2: But are the reasons to think and we're going to
Speaker 2: get into specific so this is an incredibly broad question,
Speaker 2: but just conceptually, are there reasons to think about how
Speaker 2: these risks that migrate off of bank balance sheets find
Speaker 2: a way to migrate back onto them.
Speaker 5: It's totally valid. I mean, this is part of the
Speaker 5: story of two thousand and eight right as there was
Speaker 5: this whole shadow banking sector and it looked like risk
Speaker 5: had moved, and really it hadn't. The banks brought everything back,
Speaker 5: first voluntarily and then involuntarily. So you're asking the exact
Speaker 5: right questions. The IMF is now asking these questions and
Speaker 5: citing odd lots. I don't know if you saw the
Speaker 5: recent Global financi Stability report citing Tracy on exactly this issue.
Speaker 5: You talked about the synthetic risk transfers in your intro
Speaker 5: and this idea of like, okay, but are the banks
Speaker 5: really funding it? I would say, you know, to the
Speaker 5: extent we're running risk through another balance sheet. I mean,
Speaker 5: the banks really are more protected even if they are
Speaker 5: lending to a firm that's taking credit risk, because they
Speaker 5: do have that firm's capital and they have that firm's
Speaker 5: you know, alleged skill at managing these risks. And so
Speaker 5: part of the issue with all the financial crisis stuff
Speaker 5: was a lot of it was unfunded. We can get
Speaker 5: into synthetic risk transfers, and you had that great episode
Speaker 5: about how they're different and they're funded, but broadly, Joe, yes,
Speaker 5: you're asking.
Speaker 4: The right questions.
Speaker 3: Wait, okay, I have a very basic question, but what
Speaker 3: is actually happening in the financial system when someone puts
Speaker 3: money into private credit. So say I'm an investor and
Speaker 3: I'm going to invest I don't know, a million dollars
Speaker 3: in some private credit fund. What happens to that million dollars?
Speaker 5: Well, first, Tracy, you're probably taking the million dollars from
Speaker 5: an allocation towards junk bonds investment grade credit. So that's
Speaker 5: step one. I mean, the idea of like private credit
Speaker 5: is taking all these loans from banks or is eating
Speaker 5: the bank's lunch. We can put a pin in that
Speaker 5: for now, and we should come back to that. So
Speaker 5: usually that's what's happening, is this is an allocation away
Speaker 5: from whether it's other alternatives or other corporate credit. But
Speaker 5: the reality is this is deposits move around the banking system.
Speaker 5: There's no like people talk about private credit like its
Speaker 5: deposits leaving the banking system or it's you know, deposits
Speaker 5: are going to non banks. But there is no shadow
Speaker 5: bank without a bank. Apollo has bank accounts, Blackstone has
Speaker 5: bank accounts. When you transfer money into them, they put
Speaker 5: it in their account and then it's lent on to
Speaker 5: whomever is receiving the credit, and so you're changing the
Speaker 5: nature of the aggregate deposit franchise to the extent deposits
Speaker 5: are moving to a different kind of actor. But deposits
Speaker 5: can't leave the banking system.
Speaker 2: So we just take it a little step further. Just
Speaker 2: to be clear, Okay, I sell some junk bonds. I
Speaker 2: decided to allocate a million dollars to an Apollo private
Speaker 2: credit fund. They lend the money. Is Apollo further leveraging
Speaker 2: that lending up to juice returns or how leveraged are
Speaker 2: these funds?
Speaker 5: So what we're seeing is that they're increasingly so it's
Speaker 5: pretty scarce so far. And that was part of the pitch, right,
Speaker 5: is like Apollo came along in twenty twenty two when
Speaker 5: private credit was booming and said, hey, why mean you
Speaker 5: guys thought of this? We have like one times leverage,
Speaker 5: two times leverage. That's generally sort of the space that's in.
Speaker 5: But as we've sort of seen the market mature and
Speaker 5: the market grow, like, there's a good reason to lever
Speaker 5: these things up. If you're doing effectively bank credit, which
Speaker 5: sometimes they are, there's a reason banks are ten times
Speaker 5: levered like that that's the way the funding of the
Speaker 5: system works, and that provides a whole host of other
Speaker 5: benefits to the system. But there's also a cap on
Speaker 5: how much unlevered equity is out there. If you think
Speaker 5: about what the financial system exists to do, it's to
Speaker 5: create as many financial goods for us. What we need deposits,
Speaker 5: you know, other kinds of savings on as little equity
Speaker 5: as possible. Equity is the scarce resource and it's the
Speaker 5: input to the financial systems manufacturing process. And so you
Speaker 5: cannot recreate ten x, twelve x, fifteen x leverage from
Speaker 5: the banking system on one two x leverage in private credit.
Speaker 5: And that's the limit, you know, to your fear, Joe,
Speaker 5: that's the limit of how big this thing can grow.
Speaker 5: And we're sort of seeing that a little bit is
Speaker 5: the bigger private credit grows relative.
Speaker 4: To the economy.
Speaker 5: They're sort of nearing the kink on the funding curve
Speaker 5: as far as like what amount of funding is willing
Speaker 5: to be locked up as long term assets. Like the
Speaker 5: fundamental idea that like on demand par deposits can become
Speaker 5: locked up five year equity and a private credit fund
Speaker 5: is not real.
Speaker 3: Haven't we seen some private credit funds start to look
Speaker 3: at structures where investors can take their money out as well,
Speaker 3: like instead of having the five year lockup periods, people
Speaker 3: can go in and out as they need.
Speaker 5: Definitely, I mean, the long arc of financial history bends
Speaker 5: towards banks, and we've sort of seen private credit start
Speaker 5: to look more like banks. In One of the ways
Speaker 5: is these sort of interval funds or evergreen funds they're called.
Speaker 5: And basically these are just different types of structures that
Speaker 5: allow some amount of liquidity in the short term. And
Speaker 5: this is very very marginal steps. It's gated, it's limited,
Speaker 5: but you know it's gated after a certain percentage. It's
Speaker 5: limited by quarter, there's a certain time interval in which
Speaker 5: you can get it. It's not deposits yet, but that's
Speaker 5: one of the ways which funds have started to bend
Speaker 5: towards a banking model in addition to leverage.
Speaker 2: By the way, just speaking of the history of finance,
Speaker 2: is that entities try to make illiquid things a little
Speaker 2: bit more banked. Like there was a really interesting paper
Speaker 2: that came out recently from Tim Barker and Chris Hughes
Speaker 2: about the Penn Central bailout and in there, there was
Speaker 2: some talk about the history of CDs specifically and how
Speaker 2: there at one point there was this really hard lockup
Speaker 2: on them, but then entity has found ways to sort
Speaker 2: of you could liquidate and sell your right to that CD.
Speaker 2: So they always find a way to create liquidity out
Speaker 2: of illiquidity.
Speaker 5: Yeah, you can tronch anything with cash flows. To paraphrase
Speaker 5: reportentnerial on Meet the Parents, I mean, you can get
Speaker 5: anything out of that.
Speaker 3: Speaking of traanging, I wanted to ask one more basic question,
Speaker 3: which is this term retranching of risk in the financial
Speaker 3: system has come up a number of times. So Hugh
Speaker 3: Vansteinas used it in a recent episode. I'm pretty sure
Speaker 3: you've used it as well in your writing. Exactly what
Speaker 3: risk is being retranched here? Like, give us an idea
Speaker 3: of what types of things end up in private credit.
Speaker 3: I imagine a lot of it is sort of middle
Speaker 3: market stuff, stuff that, to your point earlier would have
Speaker 3: been in the junk bond market or the leverage loan
Speaker 3: market and is now going elsewhere.
Speaker 4: Yeah, that's exactly right.
Speaker 5: And so I mean I got this term from the GFC,
Speaker 5: the global financial crisis literature. I believe it originated with
Speaker 5: Gary Gordon Andrew metric and they used it to describe
Speaker 5: increasing haircuts in two thousand and eight. So the idea
Speaker 5: that you know, you have a triple A asset, you
Speaker 5: were haircutting at one percent, but now the market to
Speaker 5: resell that collateral is worse. You're more worried about your counterparty,
Speaker 5: and so you're going to haircut it thirty percent. You've
Speaker 5: sort of retransh what you've decided is triple A, and
Speaker 5: a lot of that was driven by market perception of
Speaker 5: risk as well as increased market demands from our capital.
Speaker 5: What we're seeing in the banking system is a little
Speaker 5: bit of market demands and a little bit of regulatory demand.
Speaker 5: So obviously BASL three, you know, is looming next to
Speaker 5: the maturity wall, and it's sort of saying banks may
Speaker 5: have to have more capital. The other thing is investors
Speaker 5: depositors are looking for a little more liquidity in banks
Speaker 5: than they were pre twenty twenty three. And frankly, interest
Speaker 5: rate risk at a certain point becomes credit risk, and
Speaker 5: so when rates go to five percent, banks aren't really
Speaker 5: like trying to be in the business of managing all
Speaker 5: the credit risk at five percent that they were avoiding
Speaker 5: at zero percent, and so getting out of that left
Speaker 5: tail and sort of retranching by selling things out of
Speaker 5: the banking system is sort of the aim. So it's
Speaker 5: all those three things at once, and it makes sense
Speaker 5: for banks to lean then on prime brokerage and lending
Speaker 5: the senior layers of these funds.
Speaker 3: Wait, this reminds me of something else I wanted to ask,
Speaker 3: which is I hear a lot about comparative advantages when
Speaker 3: it comes to private credit versus banks, in the sense
Speaker 3: that private credit might be better at managing certain loans
Speaker 3: to your point about higher interest rates? Is that true?
Speaker 3: And like, what if that comparative advantage actually look like
Speaker 3: Does it just mean the analysts that private credit firms
Speaker 3: are like pouring over the paperwork more than a bank.
Speaker 5: Can I think that's right? And I know Joe has
Speaker 5: rude the failure of the high touch banks in twenty
Speaker 5: twenty three. You know that banks that care about their
Speaker 5: customers are the ones that failed. But what that misses
Speaker 5: is that community banks didn't fail, and those do the
Speaker 5: same thing, and those don't have the attention of the market.
Speaker 5: And that's sort of kind of part of the pitch
Speaker 5: of private credit as well. Is like, you know, we're
Speaker 5: operating under less transparency. Again, we're seeing give on that
Speaker 5: as they've sort of been towards banks. But in theory,
Speaker 5: this is just a product and they do have some ability.
Speaker 5: It's a smaller group, sometimes as small as one to
Speaker 5: work with the lenders. We've seen lower default rates out
Speaker 5: of private credit versus their competitors and in leverage zones,
Speaker 5: but higher losses given to fault So you can multiply
Speaker 5: those two things together and come up with some lesser
Speaker 5: loss and in that case, you know, it makes sense
Speaker 5: to be allocated a private credit.
Speaker 2: You know, what I realized a little earlier in the
Speaker 2: conversation is that I actually don't know the difference in
Speaker 2: what the shadow banks the quote shadow banks were doing
Speaker 2: prior to two thousand and eight, and how their relationship
Speaker 2: with real banks was different than the current relationship. I mean,
Speaker 2: it's interesting because I remember, you know, one of the
Speaker 2: things that was going on, I think summer two thousand
Speaker 2: and seven or summer two thousand and eight, it was
Speaker 2: like a couple bear Sterns hedge funds, like just hedge
Speaker 2: funds that seemed like a really big deal, like seemed
Speaker 2: to be systemically important I think City had something maybe
Speaker 2: do what was the nature of those quote shadow banks
Speaker 2: and how they actually connected to the regulated banks.
Speaker 5: So the short version is that the nature of those
Speaker 5: is big banks with strong balance sheets like Bear Stearns
Speaker 5: and City put their name all over those shadow banks,
Speaker 5: but didn't actually have They weren't funding them themselves, they
Speaker 5: weren't actually on the balance sheet of the banks. So
Speaker 5: when pressure came in two thousand and seven and nobody
Speaker 5: knew this was going to be like a repeat of
Speaker 5: the Great Depression, City took all that stuff back on
Speaker 5: its balance sheet to protect its reputation. Bear took one
Speaker 5: of those hedge funds on back onto its balance sheet.
Speaker 5: These banks did not have to take on this risk.
Speaker 5: But they're going, Okay, we're going to stand behind our name.
Speaker 5: We're going to stand behind our clients who thought they
Speaker 5: were buying a Bear Stearns or a City Group product.
Speaker 5: And maybe that's a risk today. I don't know, you know, Yeah,
Speaker 5: well I was just going.
Speaker 2: To ask because you see these headlines right now now
Speaker 2: like JP Morgan is going to get into private credit
Speaker 2: and so forth, and so I get the idea that
Speaker 2: this is going to be be a separate funding vehicle
Speaker 2: be like off balance kind of sounds similar.
Speaker 5: Yeah, I think that's totally a risk. Is there a
Speaker 5: world where, you know, Citygroup has to bail out its
Speaker 5: Apollo partnership because they put Citygroup's name all over it?
Speaker 3: Maybe maybe Wait, that JP Morgan mentioned just reminded me
Speaker 3: of something. But a few years ago, well actually more
Speaker 3: than a few years ago, maybe in like twenty fourteen
Speaker 3: or something like that, I remember JP Morgan basically complaining
Speaker 3: that the prime brokerage business was a lot harder nowadays,
Speaker 3: and like the margins were slimmer and stuff like that.
Speaker 3: I think that's what they said. And yeah, fast forward
Speaker 3: to twenty twenty four and it seems like prime brokerage
Speaker 3: is a moneymaker for the big banks at least what
Speaker 3: happened there.
Speaker 5: So part of it might just be the growth of
Speaker 5: private credit. I mean, it has found a niche. I
Speaker 5: would think about it like a product, you know, Like
Speaker 5: I said, it's got this middle market like you alluded to,
Speaker 5: it's sort of got a different model and there's no
Speaker 5: reason that shouldn't exist along the spectrum of bank deposits
Speaker 5: to thirty year locked up funding to fund buried treasure
Speaker 5: expedition like it exists in that spectrum, which is kind
Speaker 5: of an academic answer, but it's true. I mean Mark Rohan,
Speaker 5: CEO of a POLLA recently had a comedy, said, you know,
Speaker 5: we'll get competed with like crazy, and then what's the
Speaker 5: difference between public and private? And I think that's right.
Speaker 5: It arose as a product in the years. I mean
Speaker 5: it doubled between twenty twenty and twenty twenty three. We
Speaker 5: can talk about why, but now they have banking needs.
Speaker 5: Like I said, there's no shadow bank without a bank,
Speaker 5: and they have banking needs and hedge funds too.
Speaker 2: So my takeaway so far from this conversation is that
Speaker 2: some of the questions were asked. Is not that there's
Speaker 2: like some big looming risk out there or like oh,
Speaker 2: this is a disaster waiting to happen. But mostly these
Speaker 2: are all like reasonable questions to be asking about where
Speaker 2: at some point risks could merge, or at least where
Speaker 2: regulators maybe want to think or try to get ahead
Speaker 2: of things. What tools or specific lines of inquiry have
Speaker 2: we seen from regulators or things regulators could do, or
Speaker 2: like we want to monitor this and I know that's
Speaker 2: already you've written about this, But what are the specific
Speaker 2: mechanisms and questions and things they could do.
Speaker 5: I mean, basically, so far, what we've seen is they've
Speaker 5: just been really annoying to banks. That's a cost, right.
Speaker 5: If you talk about why the economics of private credit
Speaker 5: makes sense, some of it is that, Okay, the market
Speaker 5: demands a lot less capital for certain risks than banking regulators,
Speaker 5: and there's some supervision attached to those capital regulations too,
Speaker 5: and so to the extent you're making supervision, you know,
Speaker 5: just more costly. It's annoying and banks say whatever, you know,
Speaker 5: like JPM Yeah, they're doing ten billion of private credit
Speaker 5: on balance sheet. That's like they just found that in
Speaker 5: the couch cushions and they're doing it. They put out
Speaker 5: a press release so they can serve their clients. And
Speaker 5: this goes back to kind of what we're talking about
Speaker 5: Elier about what the differences between banks and private credit.
Speaker 5: Banks being more about managing a deposit franchise, private credit
Speaker 5: being more the lending side. But really we've seen from
Speaker 5: the Bank of England, from the ECB, from the f
Speaker 5: say in Japan, from the FED, they're all starting to
Speaker 5: just probe banks about their exposure. They're lending to private
Speaker 5: credit funds and prime brokerage. Frankly, but that's step one.
Speaker 5: I mean, you hear regulators talk either one we need
Speaker 5: more authority to regulate the non banking sector like banks,
Speaker 5: or two. You know, the conservative side is, let's be
Speaker 5: nicer with Basel three, so you don't push all this
Speaker 5: stuff into private credit. The truth is always somewhere in
Speaker 5: the middle. Right now, supervisors have just become more annoyed.
Speaker 3: That's a good way of putting it. Wait, I have
Speaker 3: a bunch of questions. Okay, One, have you noticed any
Speaker 3: like substantial differences in supervisory approaches, Like is the BOE
Speaker 3: doing something different to the FED versus the BOJ I
Speaker 3: know you said they're all in info collection mode at
Speaker 3: the moment, but like there must be some differences.
Speaker 5: So generally this stuff goes better in foreign countries than
Speaker 5: it does in the US, particularly the Bank of England.
Speaker 5: They have like a system wide stress test now where
Speaker 5: they simulate shocks in theory through like the whole financial system.
Speaker 5: They're big on macro prudential stuff over there in the US,
Speaker 5: like the fact that the f SoC, the Financial Stability
Speaker 5: Oversight Council hasn't designated black Rock or its kin as
Speaker 5: systemically important under a Biden administration, It'll never happen. And
Speaker 5: I'm not saying they should have. I mean the idea
Speaker 5: is like they're not doing banking, they have no short
Speaker 5: term liabilities.
Speaker 4: Blah blah blah.
Speaker 5: But it just doesn't get that same reception abroad. So
Speaker 5: there's more, you know. I think it'll lean harder in
Speaker 5: Europe and elsewhere, but for right now, the US is
Speaker 5: just kind of like poking at it in the stress
Speaker 5: tests and in data collection.
Speaker 2: By the way, you mentioned that, like one of the
Speaker 2: binding constraints in the financial system is how much money
Speaker 2: is just willing to be locked away on a permanent basis.
Speaker 2: This is really, though, where the role of insurers comes in,
Speaker 2: because this is money that people put into a pod
Speaker 2: and they theoretically expect to get all of it back
Speaker 2: maybe at some point over the course of a lifetime,
Speaker 2: it's cetera. But that really is a great source of
Speaker 2: cash for long term money. Can you talk a little
Speaker 2: bit more about like how big that is?
Speaker 5: Yeah, it's huge and growing. I think you're exactly right.
Speaker 5: That is sort of a sticky source of funds and
Speaker 5: if you hear Apollo talk about there a fine insurance,
Speaker 5: it sounds like it's basically unlimited. I mean, they'll say,
Speaker 5: like our limit of new private credit is finding good
Speaker 5: things to invest in, not the source of funds. And
Speaker 5: so we may see a bifurcation across the system of
Speaker 5: like do you have an ensure attached to yourself? I mean,
Speaker 5: this again goes back to sticky funny. Can you get
Speaker 5: bank leverage? Do you have an insure attached to yourself?
Speaker 5: I mean the other thing about insurance is that it
Speaker 5: still is a savings vehicle, and so there still is
Speaker 5: a limit. You know, annuities aren't on demand.
Speaker 2: But they always and they tried to like layer in
Speaker 2: stuff so that it looks more and more like an
Speaker 2: investment right right for time, and looks more and more
Speaker 2: like a mutual fund or something like that. And exactly
Speaker 2: so even there the other question, so we're talking about
Speaker 2: the distribution of risk across various entities, what about And
Speaker 2: I kind of think this might be a core question
Speaker 2: from an investor perspective. I guess, the distribution of profitability
Speaker 2: and when you look at the profits that come out
Speaker 2: of prime brokerge units at banks, how do those stack
Speaker 2: up compared to the profits of traditional banking, And is
Speaker 2: there a risk that making risky loans setting aside the
Speaker 2: risk part is a profitable business And does that ultimately
Speaker 2: impair over time how much money what we call banks
Speaker 2: can make good question?
Speaker 4: I think not.
Speaker 5: And it goes back to the limit of funding in
Speaker 5: private credit. Okay, Like take COVID for example, in the
Speaker 5: two weeks after the pandemic really hit in March twenty twenty,
Speaker 5: banks increased their business loans by twenty five percent half
Speaker 5: a trillion dollars two weeks. They didn't go to market
Speaker 5: and issue equity, They didn't go find investors. They are
Speaker 5: able to create a posits. That a key stroke, and
Speaker 5: that's always going to be the advantage of banks. And so,
Speaker 5: like I said, private credit, we're seeing them sort of
Speaker 5: get closer and closer to this kink on their funding
Speaker 5: curve where all of a sudden, the long term wealth
Speaker 5: lock up sources are scarcer, and frankly, we're seeing this
Speaker 5: a little bit. Fundraising is falling in private credit, and
Speaker 5: we're seeing more institutional investors say like, we're at our
Speaker 5: alternatives allocation and now it's all the big push is
Speaker 5: retail and again talk about looking more like a bank.
Speaker 5: Like that was one of private credit's original promises to
Speaker 5: us as well. It's like, oh, this is different, this
Speaker 5: is just safe like institutional investors. Now everyone's after the
Speaker 5: retail money. How can we make a retail vehicle, How
Speaker 5: can we tap individuals etf.
Speaker 3: They are moving into ETFs, which again is another good
Speaker 3: example of like putting a liquid wrapper on a bunch
Speaker 3: of illiquid assets.
Speaker 4: Right.
Speaker 5: That was the other thing is, oh, private credit doesn't
Speaker 5: mark to market once you have an ETF, And we've
Speaker 5: seen a bunch of banks and non banks start to
Speaker 5: build out their secondary trading desks for private credit. I
Speaker 5: mean it goes back to what Marc own said, eventually,
Speaker 5: what's the difference between public and private?
Speaker 3: Just to go back to something you touched on earlier,
Speaker 3: do you get the sense that regulatory attitudes towards private
Speaker 3: credit and banks and the relationship there are starting to
Speaker 3: change in the sense that, you know, Joe and I
Speaker 3: have talked a lot about how in the aftermath of
Speaker 3: the two thousand and eight financial crisis there were deliberate
Speaker 3: efforts to shift risk into the shadow banking system. Does
Speaker 3: it feel like maybe there's some like change in the vibes,
Speaker 3: the regulatory vibes now.
Speaker 4: Not yet.
Speaker 5: I think regulators are looking for sure, it's a matter
Speaker 5: of do they find something. I mean, you talked about
Speaker 5: this on the episode with Huge Tracy. How when you
Speaker 5: ask a private credit investor, you say like, oh, you know,
Speaker 5: are you guys eating the bank's lunch now? And they
Speaker 5: sort of wax and wane and they say, well, it's
Speaker 5: an ecosystem and we're partners, you know, And then they
Speaker 5: go in the bathroom. Let's scream in the mirror at
Speaker 5: how embarrassing that is. Like it goes back to them
Speaker 5: needing the banks for one and two. I think everyone's
Speaker 5: sort of happy with the status quo. The question is
Speaker 5: the direction of travel, and that's where.
Speaker 4: The risks are.
Speaker 2: I'm just really fascinated by this idea of like the
Speaker 2: kink and the funding curve for private credit, because I'm
Speaker 2: trying to reconcile that with this idea that at least
Speaker 2: from Apollo via all the money that they have for
Speaker 2: their insurance vehicle, it sounds like there's still plenty of
Speaker 2: money and that they don't need to go out to retail,
Speaker 2: that they don't need to make etf that they just
Speaker 2: have to find more good deals to employ all of
Speaker 2: the premiums they're collecting from insurance.
Speaker 5: Yeah, I think, like I said, we may see some
Speaker 5: kind of bifurcation. I mean there's a question about how
Speaker 5: popular annuities remain and if rates go lower and all
Speaker 5: that stuff, and I don't have a view on that. Yeah,
Speaker 5: what we see from other private credit lenders is they're
Speaker 5: chasing retail money now because institutional investors are full on
Speaker 5: private equity, which isn't given them their money back. You know,
Speaker 5: they have hedge fund allocations, they have venture capital allocations,
Speaker 5: and they say, hey, we're full on alternatives now. Insurance
Speaker 5: is definitely a space where more money can come and
Speaker 5: more diversification because it is so sticky and long term.
Speaker 5: But there's a limit to that, and it may be
Speaker 5: that to the partners go the spoils furnitures.
Speaker 2: Tracy, I don't understand why doesn't every investing firm Heaven Insurance.
Speaker 2: I mean, this is like Brookshire Hathaway, right, they just
Speaker 2: collect all those premiums and they have all this money
Speaker 2: that they can invest. It seems like such a big
Speaker 2: advantage to Heaven Insurance and I know various hedge funds
Speaker 2: they have their reinsurance thing is kind of similar. It
Speaker 2: seems like such a huge advantage, Like you.
Speaker 3: Should suggest it, Jack, we should have a make a
Speaker 3: sales pitch a deck.
Speaker 2: Like why would you be an investor without an insurance company?
Speaker 2: I don't really get it.
Speaker 3: The one thing I was thinking about, though, is just
Speaker 3: going back to this lack of deals point. It kind
Speaker 3: of feels like if you can't put your money in
Speaker 3: good deals, like if you can't get a big enough
Speaker 3: volume of those deals, then the temptation is presumably to
Speaker 3: try to eke out more returns from the ones you
Speaker 3: do get and apply of leverage. And that's again like
Speaker 3: where some of the risks could come from. That's not
Speaker 3: a question, that's just a point I will continue on.
Speaker 5: Is that correct?
Speaker 3: One thing I wanted to ask is you're obviously folks
Speaker 3: on the financial stability aspect of all of this, but
Speaker 3: I feel like there's been some macro impact from private
Speaker 3: credit as well. And if you think about, you know,
Speaker 3: financial stability is tied very much to fundamental economics, and
Speaker 3: if the economy is good, then probably you're not going
Speaker 3: to see a bunch of banks blowing up and that
Speaker 3: sort of thing. But what are you watching in terms
Speaker 3: of like the real world impact of private credit.
Speaker 5: So there's absolutely a risk. It's almost a trope now
Speaker 5: to say, like this stuff has not seen a downturn.
Speaker 5: Private credit has not seen a downturn, and I don't
Speaker 5: know what's going to happen to it in a downturn either.
Speaker 5: So sorry, that's a terrible answer, But there obviously is
Speaker 5: like a credit crisis type of risk to this, in
Speaker 5: the same way there is for leverage lending, which you
Speaker 5: know has held up well in the past. That's maybe,
Speaker 5: you know, a good analogy. I think part of this
Speaker 5: talk about stability. Private credit was really there to offset
Speaker 5: the bank's hung loans problem in twenty twenty two, so
Speaker 5: rates go from zero to five. Banks are sitting on
Speaker 5: a ton on billions of dollars of hung loans, most
Speaker 5: famously Twitter, and they're in the news again talk about
Speaker 5: the benefits of being private Like everybody knew Morgan Stanley
Speaker 5: had that Twitter a loan, like, so private credit was
Speaker 5: really there to take a lot of deals and they
Speaker 5: did a lot of refinancings in twenty twenty three. That
Speaker 5: problem is sort of worked through on the bank side,
Speaker 5: and now we're seeing the banks come back, and we're
Speaker 5: seeing private credit do payment and kind modifications, do extend
Speaker 5: and pretend type things. So the sort of longer part
Speaker 5: of higher for longer, you know, it's like it goes
Speaker 5: back to what I said about interest rate risk becoming
Speaker 5: credit risk. We're sort of seeing that in private credit.
Speaker 5: So in that sense, like it's nice that we have
Speaker 5: these two side by side systems that can sort of
Speaker 5: cushion each other, but as we've seen there increasingly becoming one.
Speaker 2: I have one last question. It has nothing to do
Speaker 2: actually with private credit, but I figure you're here and
Speaker 2: I think you might have some thoughts on this topic.
Speaker 2: We did an episode probably about two months or so
Speaker 2: ago about stable client and we saw recently Stripe made
Speaker 2: a one point one billion dollar acquisition of a stable
Speaker 2: coin companies. There are some I think issues related to
Speaker 2: financial stability related to stable coins, because anytime you have
Speaker 2: an asset or a product that's pegged one to one
Speaker 2: against the dollar, we all, you know, we can talk
Speaker 2: about money markets all the time, but actually have like
Speaker 2: a separate question than financial stability related to stable coins.
Speaker 2: Do you, as a researcher in how the financial system works.
Speaker 2: Take them seriously as something that will be important for
Speaker 2: payments in the financial system going forward.
Speaker 5: I'm going to hit you with another trope, which is
Speaker 5: that I think the tech is good, the product is not.
Speaker 5: I think this is another area where the big banks
Speaker 5: will win. I mean, it'll be it'll be a stable
Speaker 5: coin technology, but like now we don't actually experience ACCH
Speaker 5: versus you know, fed wire versus whatever else. It'll be
Speaker 5: that it's the right technology, But the ultimate question is
Speaker 5: payment in what? And you don't want the answer of
Speaker 5: that question to be USDC, like you want it to
Speaker 5: be a deposit that.
Speaker 2: I mean, I guess. My thing is, like, you know,
Speaker 2: I actually buy kind of the argument from the stable
Speaker 2: coin advocates that like it solves a lot of problems
Speaker 2: with tech interoperability, that it could never you will never
Speaker 2: get a sort of blockchain type solution from all the
Speaker 2: big banks working together because of you know, lack of
Speaker 2: trust or whatever it else. Like I buy that, but
Speaker 2: I guess, like I guess to your point, specifically, I
Speaker 2: don't know how big ultimately that demand will be, especially
Speaker 2: since you put it away from most payments in most
Speaker 2: of the world, these things are pretty abstracted away. I
Speaker 2: would I don't know most I don't want to like
Speaker 2: jump to conclusions because I know there are underdeveloped banking systems,
Speaker 2: but for much of the world, for much of the
Speaker 2: wealthy world, a lot of these problems are completely seem
Speaker 2: abstracted away.
Speaker 5: The other challenge is to go find a bunch of
Speaker 5: safe assets to invest in. You know, if you're replacing
Speaker 5: trillions of dollars of payments, you have to go find
Speaker 5: a bunch of safe facets. And that's why we run
Speaker 5: this through banks, because they don't have to find safe acets.
Speaker 5: They can back to positive.
Speaker 2: Yeah, Stephen Kelly, thank you so much for coming on AVAS.
Speaker 4: That was great.
Speaker 2: You answered a bunch of questions. I think that, least
Speaker 2: in my head had been lingering for a long time.
Speaker 4: Thanks guys.
Speaker 2: Steven is so good. He's so clear.
Speaker 3: Yes he is. It's always good to catch up with him.
Speaker 3: I mean, I do think like the circular nature of
Speaker 3: the leverage is obviously a concern. Again, like we're talking
Speaker 3: about relatively small volumes right now, but it feels like
Speaker 3: it could become problematic at some point.
Speaker 2: It's interesting. I kind of forget when I think about
Speaker 2: two thousand and eight and two thousand and nine, how
Speaker 2: much of those first like tremors, I guess of the crisis.
Speaker 2: We're literally you know, non banks. And I think you know,
Speaker 2: people ever talk about those bear Sterns hedge funds that
Speaker 2: blew up. Yeah, that was the start, but that was
Speaker 2: like really kind of I mean, there was the quant quake,
Speaker 2: what was that late two thousand and six, and that
Speaker 2: was sort of freaked the market out a little bit,
Speaker 2: But then it was really like those bear Sterns hedge funds,
Speaker 2: and then you know, you mentioned the city line and
Speaker 2: just this idea that they had these banks, they had
Speaker 2: these off balance sheet vehicles, probably for many of the
Speaker 2: reasons that you know, the same reasons that shadow banks
Speaker 2: or private credit or multi strategy hedge funds exist today,
Speaker 2: less capital intensive vehicles, and then they felt the need
Speaker 2: to bring them on maybe for reputational reasons. I think
Speaker 2: that's like a really interesting history that gets forgotten about.
Speaker 3: No, you're absolutely right, and money market funds as well.
Speaker 3: When they broke the book. You know, the other thing
Speaker 3: I was thinking about was just this idea of again
Speaker 3: liquid wrappers on ill liquid assets and I kind of
Speaker 3: think like the ultimate expression of shadow banking has to
Speaker 3: be someone putting an etf rapper like private credit.
Speaker 2: It's so perfect. They always find a way to do that.
Speaker 2: They always find we're going to get the ill liquidity premium,
Speaker 2: and then we're going to still give you the liquidity.
Speaker 2: I think one of the most important points that Steven makes,
Speaker 2: and I've heard him make it before, is just this
Speaker 2: idea that the key scarcity in the financial system is
Speaker 2: cash that's willing to be locked up, right, cash that's
Speaker 2: willing to not be sold in an instant or in
Speaker 2: a demand deposit. And so there is therefore then this
Speaker 2: natural constraint on how much, say a private credit firm
Speaker 2: could take away from the banking system, because in the end, banks,
Speaker 2: as we know, as you mentioned, are very levered. How
Speaker 2: do you recreate that leverage? How do you satisfy the
Speaker 2: financing demands of the real economy given this constraint and
Speaker 2: locked up capital. I think it's just a really important
Speaker 2: concept to keep in mind.
Speaker 3: Yeah, all right, well, shall we leave it there.
Speaker 2: Let's leave it there.
Speaker 3: This has been another episode of the All Blots podcast.
Speaker 3: I'm Tracy Alloway. You can follow me at Tracy Alloway and.
Speaker 2: I'm Jill Wisenthal. You can follow me at the Stalwart Fellows,
Speaker 2: Stephen Kelly at Stephen Kelly forty nine, follow our producers
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